One of the most difficult aspects of any financial practice sale is reaching an appropriate valuation. Often, buyers and sellers go into negotiations with values in mind. However, the case for a specific value is always stronger if that value is based on a proven methodology.
There's no valuation method that is 100 percent accurate. There are too many subjective factors involved to say with confidence that a practice is worth a specific dollar amount. One can come up with a reasonable range of values, though. By using widely-accepted valuation methods, a buyer and seller can determine an acceptable high-end and low-end on value and then negotiate between those two points. There are many popular valuation methods, but the following are three of the most popular:
1. Revenue multiple. A revenue multiple is probably the simplest way to reach a valuation. Simply multiply the practice's trailing 12 months' revenue times a multiple. The result is the firm's value. The average multiple in the industry is 2.1. So, using that multiple, a practice that has $1 million in revenue would be worth $2.1 million.
While the revenue multiple is simple and easy to understand, it does have its limitations. Primarily, it doesn't take operations, efficiency or profitability into account. For a buyer, that could be an issue. A practice that does $1 million in revenue but has inefficient operations may not be as valuable as a $1 million dollar practice that runs like a well-oiled machine.
Also, in its most basic form, the revenue multiple method doesn't differentiate between recurring revenue and new business. One way around this issue is to break the formula into two parts. You could multiply the trailing 12 months' recurring revenue times the multiple and then simply add in the trailing 12 months' new business. For example, under that method, a firm with $500,000 in recurring fee-based business and $500,000 in new commission-only business would be worth $1.55 million. The recurring business is worth $1.05 million ($500k times 2.1) and the commission business is worth $500,000.
2. Profit multiple. The advantage of the profit multiple is that it takes into account the practices’ operations and profitability. The calculation is much like the revenue multiple, but in this case you're multiplying the bottom line times an accepted multiple. The average industry multiple for this method is between four and eight, according to Succession Planning Consultants.
3. Present value of income. Accountants and analysts may tell you that this is the only way to accurately value a business. However, it's also the most complicated and has numerous subjective factors that can significantly influence the outcome. To calculate value with this method, one must first project out 10 years of revenue. You must also project the firm's margin over that period and calculate each year's profit. That means determining things like expenses, inflation, and firm growth. That can be challenging to do for a period that is 10 years in the future.
Once you've calculated those numbers, you then use a discount rate to calculate the net present value of that stream of income. Even adjusting the discount rate by a tenth of a percent can heavily influence the final value, so it's important to be confident in every component of the analysis. If you choose to go this route, it may be best to hire a CPA or analyst to assist.
Valuation is important to get right, but don't get hung up on finding the exact number. Rather, try to determine a range that seems appropriate and use that as your guide in negotiations.
Phillip Flakes is Co-Founder and CEO of Succession Link